Keep emergency reserve, stay realistic on mutual funds

Sept. 30, 2010 12:00 AM

Question: I am retired and on permanent disability in my 50s, and receive tax-free disability income equal to two-thirds of my retirement salary. Should I keep three to six months' worth of this income tied up in money market or similar type of investments as opposed to investing it in various stock and/or bond mutual funds?

Also, we have an expenditure coming up for my child's college education. Would it be better to borrow from our home equity and pay 5 percent interest, rather than liquidate shares in a mutual fund that has produced 10-plus percent yearly average returns over nearly 20 years for me?

Answer: Despite the disability payments, I would encourage you to retain an emergency reserve of at least three months' worth of living expenses. Surprises happen - your roof can spring a leak, your car breaks down, the kids have an emergency need for money, etc.

As for borrowing to pay for college expenses vs. tapping into your investments, either approach can make sense. If you can reasonably expect to earn more than the 5 percent interest cost by investing the money, borrowing is fine.

Going forward, you shouldn't expect your best mutual funds to return more than 10 percent, which is the historical average return for stocks. Also, recognize that you could draw this money from your emergency reserve, which surely is yielding less than 5 percent.

Q: Of which stocks does the S&P 500 consist? How do people calculate the Dow Jones Industrial Average each day? Does the volume of each stock sold that day have any effect in calculating the Dow Jones?

A: The Standard & Poor's 500 index consists of 500 large U.S. company stocks. These are not necessarily the 500 largest companies, but most of the companies in this index are among the 500 largest.

Standard & Poor's website (standardandpoors.com) has a complete list of the current 500 companies in the index.

The Dow Jones Industrial Average is calculated by adding up the stock prices of all the stocks in the index and then dividing by a divisor, which changes through the years based upon stock splits. Thus, a Dow stock that is trading around $120 per share has a much greater influence on movements in the Dow index than Dow stocks priced at, say, $30 per share.

Consider that a 5 percent move in the higher-priced stock translates into a $6-per-share change, but the $30 stock translates into a $1.50-per-share change. Thus, the same percentage move for the higher priced stock has four times the effect on the Dow index.

The S&P 500 index, in contrast to the Dow index, is a capitalization-weighted index. What this means is that each stock in the index is in proportion to its total market value in the S&P 500 index. So, the largest company stocks in the index have a far greater impact and weighting than those of the smallest company stocks.